Getting started on the path to Financial Independence (FI)

It’s never too late to get started towards FI

In the Get FI article I outline the reasons to get FI, and 5 major steps to get there. Here I outline getting started on financial independence.

Getting Started on Financial Independence
Be wise with your recurring expenses and investing costs
Evaluate recurring expenses and cut them mercilessly

Do you know all your recurring monthly expenses? Are they all necessary? If not, do they provide enough value to justify their cost? By thinking carefully about just 4 items; cable TV, cell phone, books and coffee I showed how to reduce expenses by $222 per month. What expenses can you reduce or eliminate? Do you need to buy the latest video games or can you play older titles that cost 1/3 as much? Are you using your gym membership? Everyone is different here. If you have a golf membership and use it twice a week that may provide good value, but if you have a gym membership and use it twice a month…. Be ruthless and think outside the box. If your hair style is a number 3 buzz cut, can your spouse cut your hair? How much would that save per month, year, and ten years? Keep going until you have gotten to a balance where you feel confident each monthly expense provides enough value compared to the freedom it would give you once you are FI if you cut it.

Take advantage of free money from your employer

Does your 401k or 403b provide a match? Contribute at least enough to capture the employer match. By cutting recurring expenses you might free up enough $ to allow you to match your employers contributions.

Identify your investing costs

If you have a 401k plan /403b and or a traditional IRA what are the expense ratios (ERs) and what is that costing you a year? The expense ratio is what it costs you to hold the fund. For example if you have a balance of $100,000 and an expense ratio of 1% you are paying $1,000 a year. Expense ratios can vary greatly for mutual funds within retirement plans. For example my employer provides a 403b plan from TIAA-CREF. There are many investment choices but let’s look at:

a) an all-in-one fund:

TIAA-CREF Lifecycle 2030 Fund (Institutional). Symbol: TCRIX. Expense ratio (net): 0.42% (as of August 2017)

From the TIAA CREF website: “The Lifecycle 2030 Fund seeks high total return over time through a combination of capital appreciation and income. Each of the TIAA-CREF Lifecycle Funds is designed to provide a single diversified portfolio managed with a target retirement date in mind. The target date is the approximate date when investors expect to begin withdrawing money from the Fund. Each portfolio invests in several underlying equity, fixed-income and direct real estate funds. Currently, the Lifecycle 2030 Fund’s target allocation consists of an equity/fixed-income/direct real estate mix of approximately 69.6%/27.9%/2.5%.

b) an equity (stock) account:

CREF Stock Account (R3) Symbol: QCSTIX. Estimated expense ratio 0.32% (as of August 2017)

This variable annuity account seeks a favorable long-term rate of return through capital appreciation and investment income by investing primarily in a broadly diversified portfolio of common stocks. Under normal circumstances, the account invests at least 80% of its assets in broadly diversified portfolio of common stocks.

c) an international equity account:

CREF Equity Index Account (R3). Symbol: QCEQIX. Estimated expense ratio 0.33% (as of August 2017)

From the TIAA CREF website: “This variable annuity account seeks a favorable long-term rate of return through capital appreciation and income from a broadly diversified portfolio that consists primarily of foreign and domestic common stocks. Under normal circumstances, the account invests at least 80% of its assets in equity securities of foreign and domestic companies.”

d) a bond account:

CREF Bond Market R3. Symbol QCBMIX. Estimated expense ratio 0.29% (as of August 2017)

From the TIAA CREF website: “This variable annuity account seeks a favorable long-term rate of return, primarily through high current income consistent with preserving capital. Under normal circumstances, the account invests at least 80% of its assets in a broad range of fixed-income securities. The majority of the account’s assets are invested in U.S. Treasury and other governmental agency securities, corporate bonds and mortgage-backed or other asset-backed securities.

These costs, 0.42% for the all-in-one fund, or 0.32%, 0.33% and 0.29% for the equity, international equity and bond accounts respectively, are not considered high by industry standards. In fact before I understood the impact of costs, I used to own funds with even higher expense ratios. But let’s look at what the 0.42% expense ratio will cost for an investment of $10,000 over a 25 year time frame. We will use the Vanguard cost tool here with the default setting of a 6% average annual return.

After 25 years, 89% of the funds returns would be kept, $87,568.97, and 11%, $10,778.09 would be lost to expenses. Ouch.

Is there a lower cost alternative?

In the Bogleheads and the Three Fund Portfolio article I discuss a low cost (0.1542% expense ratio) Three Fund Portfolio approach using Vanguard funds. But what if your employer does not have Vanguard funds? It turns out my TIAA-CREF plan does have lower cost choices for:

a) equities

TIAA-CREF Equity Index Fund (Institutional) Symbol: TIEIX, Expense ratio (net): 0.05% (as of August 2017)

From the TIAA CREF website: “The fund seeks a favorable long-term total return, mainly through capital appreciation, by investing primarily in a portfolio of equity securities selected to track the overall U.S. equity markets based on a market index. It normally invests at least 80% of its assets in equity securities within its benchmark index.

b) international equities

TIAA-CREF International Equity Index Fund (Institutional) TCIEX: Expense ratio (net): 0.06% (as of August 2017)

From the TIAA CREF website: “The fund seeks a favorable long-term total return, mainly through capital appreciation, by investing primarily in a portfolio of foreign equity investments based on a market index. It normally invests at least 80% of its assets in securities within its benchmark index.”

So a Three Fund Portfolio can be built using TIAA-CREF equity funds and their bond account:

TIAA-CREF Equity Index Fund: TIEIX. Expense ratio: 0.05%

TIAA-CREF International Equity Index Fund (Institutional) TCIEX. Expense ratio: 0.06%

CREF Bond Market R3. Symbol QCBMIX. Estimated expense ratio 0.29%

So for a 30 year old who uses the age in bonds formula with 20% of stock funds in international for a Three Fund Portfolio, the TIAA CREF Three Fund Portfolio would be:

30% in CREF Bond Market R3. Symbol QCBMIX. Estimated expense ratio 0.29%

56% in TIAA-CREF Equity Index Fund, TIEIX. Expense ratio: 0.05%

14% in TIAA-CREF International Equity Index Fund, TCIEX. Expense ratio: 0.06%

With this weighting the overall expense ratio would be: 0.0982%

Let’s look at how the 0.0982% expense ratio compares to the 0.42% expense ratio from the all-in-one fund for an investment of $10,000 over a 25 year time frame. Again, we will use the Vanguard cost tool here with the default setting of a 6% average annual return. We have to round .0982% to .011% as the tool does not accept .0982% and the next setting available after rounding up to 0.1% is 0.11%:

After 25 years:

For 0.42%, 89% of the funds returns would be kept, $87,568.97, and 11%, $10,778.09 would be lost to expenses.

For 0.11%, 97% of the funds returns would be kept, $95,409.70, and 3%, $2,937.36 would be lost to expenses.

So you would save $10,778.09 – $2,937.36 = $7,840.73 in expenses

But wait a minute, the all-in-one-fund is different than the Three Fund Portfolio

Yes it is and it might perform better, or it might not. But it will cost more in expenses.

Thinking of your portfolio as a whole may allow you to cut costs further

The CREF Bond account QCBMIX, in the TIAA-CREF Three Fund Portfolio above has the highest cost of the three funds, an expense ratio of 0.29%. But what if you had a Traditional IRA account at Vanguard in your portfolio and you could keep your bond allocation there, and hold only your US equity and International equity funds in your TIAA-CREF 403b? Then your three fund portfolio might look like this:

30% in Vanguard Total Bond Market Fund (VBMFX). Expense ratio 0.15%

56% in TIAA-CREF Equity Index Fund, TIEIX. Expense ratio: 0.05%

14% in TIAA-CREF International Equity Index Fund, TCIEX. Expense ratio: 0.06%

Then your weighted expense ratio would be: 0.0814%, even better.

Summary

Two first steps you can take on the path to FI are to 1) mercilessly reduce recurring expenses and 2) determine your investing costs and take steps to minimize them. It’s a good idea to develop an investment policy statement before making any changes to a portfolio. Note that buying and selling funds in a taxable account can trigger taxes. Let’s look at a summary of the investment costs from the three options above:

Portfolio type Symbol(s) and % of portfolio ER Cost of a $10,000 investment over 25 years*
TIAA-CREF all-in-one fund TCRIX (100%) 0.42% $10,778.09
TIAA-CREF 3 fund portfolio QCBMIX (30%) TCIEX (56%) TIEIX (14%) 0.0982% $2,937.36
TIAA-CREF/Vanguard 3 fund portfolio across retirement accounts VBMFX (30%) TCIEX (56%) TIEIX (14%) 0.0814% $2,409.52

*expense ratios were rounded up to the closest higher value the Vanguard cost calculator provided. For 0.0982%, 0.11% was used. For 0.0814%, 0.09% was used.

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